Why Interest Rates Will Rise a Lot Well Before the Federal Funds Rate Is Raised

The Fed Balance SheetThere is a belief among some people that interest rates will not increase significantly until the Fed (Federal Reserve) raises the federal funds target rate from its current 0-0.25% level, which does not figure to occur until about the second half of 2015.  This is definitely a misconception.

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The federal funds rate is just one particular lending rate, and it is a very short-term rate.  The federal funds rate is the interest rate at which depository institutions (e.g., banks) lend excess Fed reserve balances to each other overnight.  Required (non-excess) Fed reserve balances are funds that depository institutions must hold in reserve at the Fed.  Currently, the reserve requirement is 0% for $0 to $12.4 million of specified deposit liabilities (e.g., savings accounts), 3% for more than $12.4 to $79.5 million of specified deposit liabilities, and 10% for more than $79.5 million of specified deposit liabilities.

If necessary, the Fed buys or sells government securities to make the actual federal funds rate the same as or very near the federal funds target rate.  Very short-term securities are bought or sold because the Fed is influencing a very short-term (i.e., an overnight) rate.  For this and other reasons, a change to the federal funds rate has a knock-on effect upon other very short-term interest rates.  It also has a knock-on effect upon other-term interest rates, but to a much lesser degree.

Eurodollar LIBOR (London Interbank Offered Rate) interest rates are short-term rates for international interbank U.S. dollar loans.  LIBOR rates are not directly related to the U.S. federal funds rate.  They are important because many U.S. loan interest rates are based upon them.  The federal funds target rate has been 0-0.25% since 12/16/08, at which time it was lowered by 0.75-1.00%.  After this occurrence, the 1-month Eurodollar LIBOR rate bottomed at 0.328% on 1/15/09; and the 12-month Eurodollar LIBOR rate bottomed at 1.737% on 1/14/09.  The following chart shows peaks and troughs in Eurodollar LIBOR rates from this time forward.

 

Date 1-Month LIBOR Date 12-Month LIBOR Notes
1/15/09 0.328% 1/14/09 1.737%
3/10/09-3/11/09 0.564% 3/11/09 2.297% Near stock markets trough.  (Moment of greatest U.S. financial crisis fear.)
2/16/10-3/5/10 0.228% 3/4/10-3/5/10 0.834%
5/26/10-5/27/10 0.354% 5/26/10 1.224%
6/15/11-7/12/11 0.185% 6/14/11-6/15/11 0.720%
1/9/12-1/10/12 0.296% 1/4/12-1/9/12 1.130%
3/7/13 0.202% 3/7/13 0.737% Most recent data.

The U.S. financial crisis elevated Eurodollar LIBOR rates for a while; but you can see that Eurodollar LIBOR rates changed a lot independent of this, and that the changes were more pronounced for the longer-term LIBOR rates.  You can also see that Eurodollar LIBOR rates are currently at low levels.

The following is a chart showing peaks and troughs for 5-year, 10-year, and 30-year Treasury interest rates since the federal funds target rate was lowered to 0-0.25%.  Notice the large changes in rates.  Also, notice that these interest rates began rising, versus falling, soon after the federal funds target rate was lowered to near 0%.  Also, notice that these interest rates are currently relatively low.

Date 5-Year Treasuries Date 10-Year Treasuries Date 30-Year Treasuries
12/18/08 1.27% 12/30/08 2.09% 12/18/08 2.55%
6/8/09 2.93% 4/5/10 3.99% 4/6/10 4.84%
11/4/10 1.03% 10/8/10 2.38% 8/26/10 3.53%
2/10/11 2.40% 2/8/11 3.73% 2/10/11 4.77%
7/24/12 0.55% 7/24/12 1.40% 7/25/12 2.47%
3/7/13 0.85% 3/7/13 1.99% 3/7/13 3.20%

Longer-term interest rates can be similar to or very different from very short-term rates like the federal funds rate.  Longer-term rates somewhat anticipate what the interest rate environment will be like in the future, in addition to accounting for what the interest rate environment is like today.  For instance, the current 30-year Treasury bond rate is somewhat anticipating what interest rates will be like in each year to 3/7/43 because some of these bonds are being bought to be held to maturity.

Currently, the Fed is buying $45 billion of long-term Treasuries per month and $40 billion of RMBSs (residential mortgage-backed securities) per month.  Also, the Fed is reinvesting all RMBS principal payments received in RMBSs.  As of 3/6/13, the Fed was holding over $1 trillion of RMBSs.  Also, the Fed is reinvesting all matured federal agency debt in RMBSs.  As of 3/6/13, the Fed had about $22 billion of federal agency debt maturing in one year or less.  When the Fed stops doing any or all of these things, it will lessen the demand for long-term Treasuries and RMBSs and, via a knock-on effect, other longer-term debt.  This will influence longer-term interest rates to rise.

For the sake of simplicity, let us assume that the $85 billion per month of Treasuries/RMBSs buying continues for another six months and the two reinvestment programs continue for another 12 months.  The QE-related (quantitative-easing-related) aspects of the Fed’s balance sheet seem as if they will, then, look something like the following going forward.

In Billions 3/6/13 3/6/14 9/6/15 3/6/18 3/6/23
U.S. Treasuries $1,761.76 $2,031.45 $1,867.09 $1,593.15 $716.82
Maturities $0.31 $164.36 $273.94 $876.34
Purchases $270.00 $0.00 $0.00 $0.00
Federal Agency Debt $73.59 $51.41 $33.78 $4.39 $2.35
Maturities $22.18 $17.63 $29.39 $2.04
RMBSs $1,015.94 $1,278.12 $1,151.40 $948.83 $610.09
Maturities / Retained Principal Payments $0.00 $126.72 $202.57 $338.74
Purchases $240.00 $0.00 $0.00 $0.00
Total $2,851.29 $3,360.98 $3,052.26 $2,546.37 $1,329.25

Notes:

(1) The 9/6/15 and 3/6/18 Maturities figures are estimated, but the totals of the two figures for each debt type are exact.

(2) The 9/6/15, 3/6/18, and 3/6/23 Maturities / Retained Principal Payments figures are estimated.

(3) Assumes no U.S. Treasuries, federal agency debt securities, or RMBSs are sold.

Notice that, in this scenario, the Fed’s balance sheet begins shrinking after 3/6/14, about 1.5 years before the federal funds target rate figures to be raised.  Once the Fed’s balance sheet begins shrinking, a monetary tightening effect takes place.  Normally, returned principal is reinvested or otherwise spent.  In this case, the Fed will not reinvest or otherwise spend, but instead remove (non-physical) currency from circulation.

It is important to emphasize that the above scenario assumes, as already noted, that “no U.S. Treasuries, federal agency debt securities, or RMBSs are sold”.  Fed Chairman Ben Bernanke said that the Fed may sell the securities bought via QE after the federal funds target rate is raised, but the Fed may just wait for some or all of the securities that have not already matured to mature.  If some or all of these securities are sold, the Fed’s balance sheet will shrink more quickly than shown in the scenario above after about 9/6/15, when the federal funds target rate figures to be raised.  If some or all of these securities are sold, it will influence interest rates to rise.  If none of these securities are sold, it may be because interest rates have already increased a lot.

More specifically, the FOMC (Federal Open Market Committee) decides when to revise the federal funds target rate.  The committee said that they anticipate keeping the federal funds target rate unchanged until the unemployment rate drops to 6.5%, as long as projected inflation one to two years ahead remains at or beneath 2.5% and “longer-term inflation expectations continue to be well anchored”.  The consensus projection of the 19 members and potential members of the committee has unemployment dropping to 6.5% in about the third quarter of 2015, without projected inflation becoming a concern.  The committee is not obligated to raise the federal funds target rate immediately after the 6.5% unemployment rate is reached, but the projections of the 19 committee members and potential committee members indicate they will.

Stock prices tend to change in anticipation of what will happen, versus on what is happening.  Even though they change on current events, the most important question is:  “What does this mean about 3-6 months from now?”  Interest rates and fixed-income securities prices are similar in this respect.  Smart investors will not wait for QE to be lessened or end, the Fed’s balance sheet to begin shrinking, or the federal funds target rate to be raised.  They will anticipate these things.  You should anticipate these things too.

 

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Comments

  1. Lou says

    I think you are incorrect in your assumption that the Fed has indicated it will raise the Fed Funds rate when unemployment hits 6.5%. Rather, they said they are committed to the QE program until they hit this benchmark and inflation is not above 2.5%.

    • Kurt Shrout says

      Per the last FOMC statement: “…the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent…”

  2. Pacioli says

    “When the Fed stops doing any or all of these things, it will lessen the demand for long-term Treasuries and RMBSs and, via a knock-on effect, other longer-term debt. This will influence longer-term interest rates to rise.”

    This is a dangerous (and widespread) misconception. This premise assumes that no other parties will be interested in buying the securities that the Fed is currently buying. The only scenario where that would be true is where financial institutions have superior opportunities to lend and invest capital (i.e. a sustained economic recovery). While it could happen, there is no evidence presented to support its likelihood.

    • Kurt Shrout says

      It is not a misconception. Anytime a buyer no longer exists, particularly a very large one, it lessens the level of demand and influences prices lower. Of course, others will be willing to buy the securities instead; but the securities will sell at a lower price (and higher yield) than they would have if the no-longer-existing buyer (the Fed) was still buying. Also, the U.S. has been in economic recovery for over 3.5 years; but the recovery has been moderate. The consensus is that the pace of recovery will pick up in 2014 and beyond.

      • Pacioli says

        It is indeed a misconception.

        Again, the assumption that “the securities will sell at a lower price” is just that – an assumption. There is no evidence presented to support the case for these lower prices. Why not higher prices?

        “The consensus is that the pace of recovery will pick up….”

        ‘The consensus’ is usually wrong, especially at turning points. What was “the consensus” in late 2007?

        • Drew says

          I agree entirely, and all it takes is a quick look at a chart of treasury prices during each QE program to see that the assumption that interest rates will rise when QE is stopped, is patently false. In actuality, QE has caused rates to rise each time it’s been implemented, from start to finish. The logic is simple; the Fed is pushing people out of bonds and into stocks. If/when that stops, and people believe the Fed has been the key player in pumping up the stock market, they again might go back into the safety of bonds for fear of falling risk asset prices.

          • Kurt Shrout says

            Pacioli,

            I did not Reply to you before because, in part, it was difficult for me to take you seriously. Also, how do I respond without being unkind? (1) You quoted me significantly out-of-context. (2) You stated that “there is no evidence presented to support the case for these lower prices”, when I presented plenty of evidence―you just chose to ignore it. (3) You stated that “the consensus is usually wrong”, which it clearly is not. (The consensus is usually about correct. When it turns out to be incorrect, it gets a lot more publicity.)

            Drew/Pacioli,

            The overall effect of QE has been to drag and hold down interest rates. It is not significant whether interest rates rose or fell from their current level in the relatively short period immediately after a QE program was announced or initially implemented. There were too many other factors in play that make the short-term results potentially deceptive. Also, the Fed signals what it will or may do in advance; so the announcement or initial implementation date of a program is not necessarily a good start date for measurement purposes.

            The basic principle of supply and demand is applicable here. The Fed did and is competing to buy Treasuries and RMBSs, so they drove/held and are holding down interest rates for these securities and, via a knock on effect but less so, other securities. When the Fed stops competing to buy these securities or, even, becomes a seller, the effect will be reversed. There is no rocket science here.

            To quote myself from a previous article found at http://www.learnbonds.com/strategies-for-the-current-low-and-rising-interest-rates-environment/: “Per the February 2013 Wall Street Journal Economic Forecast Survey (of economists), the 10-year U.S. Treasury yield is expected to be 2.4% in December of 2013, 3.0% in December of 2014, and 3.6% in December of 2015.” These economists are definitely not always correct, but they are far more likely to be correct than you are.

            Pacioli,

            Please do not Reply back. If you still disagree, which I am certain you do, let’s just let it drop. We had our say and we painted different pictures. People can look at these different pictures and decide for themselves.

        • Pacioli says

          Let’s take these in turn – a lot to address:

          1) To claim that the quotes are “out-of-context” is laughable. The full context is clearly visible by scrolling a few inches up the page.

          2) The evidence you presented merely details the level of involvement of the Fed in the relevant securities market. This is a far cry from presenting evidence to support a case for lower prices if/when the Fed starts pulling back. For this line of thinking suffers from the ‘all else equal’ fallacy. Namely, one buyer’s (the Fed) decision to begin to pull back is no reason to assume that other
          buyers will not step in. No evidence whatsoever was presented with respect to any other market participants. So making the case for ‘all else equal’ requires much more evidence.

          3) I guess we can agree to disagree regarding the forecasting record of Wall Street economists. You never answered my question – what was the consensus in late 2007?

          “The overall effect of QE has been to drag and hold down interest rates.” Maybe, but maybe not. There is certainly not enough evidence in your article to just throw around blanket statement assumptions such as this. The domestic economy is in its fifth year of massive private sector debt deleveraging. So who is to say that rates would be any different with or without Fed involvement? One need not even confine the timing on QE’s effect on rates to “the relatively short period immediately after a QE program was announced or initially implemented” in the way that you assert in your prior comment. An unbiased look at the chart in the link I presented shows that there is wide movement in rates (both up and down) throughout the entire period of the QE programs. This is true whether you pick a starting point of several months prior to each QE announcement, the actual announcement dates, or the
          actual program commencement dates. So again, to assert such certainty around your assessment of QE’s effects on rates is fairly sloppy.

          “The basic principle of supply and demand is applicable here.” While the principle of supply and demand is always applicable, the evidence in your article is narrowly focused on one market participant (the Fed). Again, your article fails to make any case that all else will remain equal if/when the Fed does pull back. Without making that case, it is impossible to make a remotely
          credible argument as to the direction of rates.

          “Please do not Reply back.” Laughable and pathetic.

          • Kurt Shrout says

            Pascioli,

            I would have very much appreciated it if you did not Reply back. I am very bored by responding to your comments, and I have a lot of other, more important things to do.

            (1) You quoted me as writing “the securities will sell at a lower price”, and you acted as if I wrote this; but I wrote “the securities will sell at a lower price…than they would have if the no-longer-existing buyer (the Fed) was still buying”. There is an important difference between the two that I should not have to define for you.

            (2) It would have been too long of an article and impossible do well if I attempted to cover all potential buyers. Besides, I did not need to cover all potential buyers. The basic principle of supply and demand tells us that, when we lose a big buyer, prices are strongly influenced fall. I never said that prices are definitely going to fall. No one can know something like that. I said that, in consideration of the evidence presented, the odds are well in favor of it―and you should be able to make the mental leap that, if I was aware of another factor(s) that will likely override the influence of the end of QE, etc., I would have, at least, mentioned it.

            (3) Don’t be silly. One or a limited number of incidents does not make the consensus usually wrong. I am not going to go through an exercise whereby I list off a zillion correct or about correct consensus projections to illustrate a point which should be obvious to you. The statement “the overall effect of QE has been to drag and hold down interest rates” is accurate. The Fed has done and is doing a ton of buying. This definitely had a significant impact. It is impossible for it not to have. It’s simple supply and demand. Exactly how much of an impact is unknown.

            Please stop boring me to death with your pseudo intellectualism, and please stop wasting my very valuable time.

  3. says

    Why do you assume that the fed will quit adding to it’s balance sheet? There will not be a shortage of crisises in the near future – there will always be a reason for fed intervention to keep the flow of money (spice) moving to increase debt. After all our entire financial system is based on increasing debt – if that does not continue then we will crash and burn.
    Also, with the increasing debt of now almost $17T I think the fed will determine it acceptable to have a balance sheet which is some ‘percentage’ of teh EVER increasing debt.

    • Kurt Shrout says

      Snoopy the Economist,

      The Fed plans to stop adding to its balance sheet and, then, shrink it and/or let it shrink. Most knowledgeable and intelligent observers, by far, see the Fed doing exactly this. The timing for exactly when and how this will occur is debatable though. Last I saw, the consensus of economists was that the Fed will ease QE in November of ’13 and end QE in May of ’14.

      There is always significant trouble somewhere in the world; however, the trouble needs to be of a certain ilk and magnitude to warrant Fed balance sheet action. At the moment, it does not appear there will be anything that will derail the Fed from its balance-sheet-shrinking plan.

      The way it appears now, the possibility of too strong future inflation will keep the Fed from maintaining a large balance sheet further into the future than planned. If future inflation appears as if it will be well below the 2% target, I think the Fed may hold and/or buy some Treasuries and, then, forgive the debt, thereby lessening the national debt. They will only do this if the marketplace allows them to do it without stoking inflation. You should notice I said “I think” and “may”, which, in this case, means this is speculation on my part. It is unlikely to happen anyway because inflation will probably be a big enough concern to prevent it.

  4. Flibber says

    From 3/1/2014, it looks as if QE won’t taper to END until the end of 2014; it looks as if an unemployment rate lowering to 6.5 is explicitly NOT going to cause the Fed to increase interest rates. I’d say there’ll be no increase in the overnight rate until the end of 2015 — if then; and it will be exceedingly modest; perhaps 0.05%.

    • Kurt Shrout says

      Flibber,

      I wrote this article about a year ago, and it is out-of-date now. The principles in the article are still applicable, but the expected timings are different. An unemployment rate of 6.5% was never going to “cause” the Fed to increase “interest rates”. It was only going to, less the unexpected, allow them to possibly increase the federal funds target rate. Also, 6.5% has not turned out to represent the level of employment health that the Fed anticipated it would. (6.5% is going to represent a much less healthy situation than anticipated.) This is not very surprising since the 6.5% relates to the U-3 measure of unemployment, which is an incomplete measure. For more regarding this, you can see my June 14, 2013 article titled “The True U.S. Unemployment Rate Is About 11.3%”. The Fed tends to increase or lower the federal funds target rate in increments of 0.25%. The current target is 0.00-0.25%, which makes things a little different. When the Fed increases, it will very likely be to 0.25%, 0.50%, or 0.75%.

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